Chinese Puzzle

As oil flirts with the $55/bbl level again, and as the world's banks slowly abandon the dollar as their preferred reserve currency, the assumption among certain writers has been that this is all downside for the United States and upside for her competitors in Asia. The point of a declining currency, some say, is that it forces declines in U.S. imports. But, goes this logic, with China bolted to the dollar, the principle cause of the U.S. trade deficit remains unaffected by this.

But China doesn't get off scot-free in this. With a dollar in decline, the yuan also needs to take a beating. The Chinese have really only two choices in the management of the current accounts deficit, neither of them good: they can continue to finance the trade deficit by buying Treasuries, or they can unshackle the yuan and let their cost competitiveness evaporate. With the former, they risk inflation of energy prices, which are still dollar-denominated. This is a double- or quadruple-whammy for China, because its industries are far less efficient than those of the industrialized West.

The Chinese ultimately have to get a return on their income stream, something low-interest Treasuries aren't likely to provide. With a free-floating yuan, they risk social and political turmoil as Chinese wages suddenly increase relative to the rest of the industrialized world. Neither outcome is especially good for China in the short term, but China will fight floating the yuan. Ultimately it may not be possible for them to avoid it.